We are just starting earnings season, when companies will be reporting how much money they made in the fourth quarter of last year. This is always an important time, as stock values depend crucially on how much money companies make. But this season will be especially important.
The reason is that this quarter there are two key issues we need to watch. In the short term, with the economy hit by the winter Delta wave and the start of the Omicron wave, the question is: How much damage was done? Will the fourth quarter be a weak one? In the longer term, this quarter’s results will give us some guidance as to whether the very strong earnings growth we saw last year will continue for another couple of quarters—or peter out.
High Hopes?
Expectations are for strong growth. Earnings are expected to be up by more than 20% for the fourth quarter, which will likely be revised up as we see more data. This will be the fourth quarter in a row we see such strong growth. For the year, earnings are expected to rise by more than 40%. Even though that 20%-plus growth is healthy, it is still down materially from the past three quarters. Some degree of slowdown is apparently baked in the cake, but the question will be: How much?
So far, the news is good. According to FactSet, for the companies that have reported so far (which is only 4% of the S&P 500), that 20%-plus target is doing better than holding up. More than three-quarters have reported earnings higher than expected, and nine of 10 had better revenue than expected. The earnings beats are also widespread, with eight sectors reporting higher earnings than were expected at the end of last year. While it is early days here, with 96% of companies still to report, the data so far suggests analysts have finally figured out how to set their expectations. That also implies that economic and market conditions have once again become dominant in company results, rather than the pandemic or federal policy changes.
Real Headwinds
Which is not to say we are out of the woods, because that might change, and we need to watch for that. Even if the numbers for last quarter come in as expected, the commentary will give us guidance as to the likely course of the next couple of quarters. Three of five companies have so far cited labor costs as a problem on earnings calls, for example. This is the highest proportion ever recorded. Shortages are also having an unprecedented impact, as shown by earnings calls. The headwinds are real. At the same time, 17 of the 20 companies also reported the ability to raise prices. While there are real headwinds, companies have so far been able to navigate them and still raise earnings substantially.
Looking forward, the fourth quarter earnings data will also set the stage for 2022 earnings estimates. Right now, per Yardeni Research, expected earnings growth is expected to be much lower for 2022, at around 10% to 15% for the year. This makes sense, as the year-on-year comparisons are difficult given the strong 2021 results. But if the fourth quarter numbers do beat expectations? It also creates the possibility that market expectations for 2022 earnings will adjust up, which should be constructive for markets.
The Number to Watch
Earnings growth overall for the fourth quarter is the number to watch. At 20%, we are matching expectations, and markets should respond with a shrug, and that probably extends up to 25% growth or so, given analysts’ historic tendency to come in too low. Above 25% growth, especially in the face of the winter Delta and Omicron waves, that says that companies are, in fact, able to keep growing earnings more quickly—with likely positive consequences for 2022 earnings.
So far, so good. But as noted, we are still very early in the reporting season. From what we know now, though, there is likely to be more upside than downside from the news. And that is a good place to be as we start 2022.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held Registered Investment Adviser-broker/dealer. He is the primary spokesperson for Commonwealth’s investment divisions. He is also the author of Crash-Test Investing, a must-read primer for Main Street investors seeking to help insulate their portfolios against a market crash. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan. Forward-looking statements are based on our reasonable expectations and are not guaranteed. Diversification does not assure a profit or protect against loss in declining markets. There is no guarantee that any objective or goal will be achieved. All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance is not indicative of future results.